Fed who? Interest rates are already falling

A perspective from E*TRADE Securities
06/28/19

The Federal Reserve can at times seem like the man behind the curtain in the Land of Oz. But though we imagine the Fed spinning wheels and pulling levers, there’s only so much the central bank can do to guide interest rates and steer the economy.

Because monetary policy is intuitive, investors often fixate on the Fed at the exclusion of fiscal policy and broader economic trends. That’s not to say the Fed is a humbug, as the scarecrow might suggest—but perhaps Powell & Co. aren’t nearly as omnipotent as some imagine.

A case in point is today’s interest rate environment. Even though the Federal Reserve hasn’t eased monetary policy in more than a decade, interest rates have fallen steadily over the past year, which has taken many experts by surprise and sapped some of the Fed’s potential dry powder.

Consider:

• As recently as last November, the 10-year Treasury was hovering just above the psychologically significant 3% level as investors began scooping up government debt. The widely followed benchmark is now yielding roughly 2% but has recently fallen below that threshold—the first time it has breached the 2% floor since 2016.1

• 5-year yields are more than 100 basis-points lower than they were a year ago.

• Short-term Treasury yields have also fallen measurably year-to-date, although they’re higher than they were last year due to the partially inverted yield curve.

And all of this has happened without any prompting from the Fed.

Source: FactSet Research Systems

Why are bond yields falling?

Falling yields are partially rooted in a flight to quality that accelerated in May but has been in the works since last November, when 10-year Treasury yields were north of 3%.1

As trade relations deteriorated and market volatility spiked, investors fled riskier assets in favor of Treasuries, which pressured yields across all maturities. Expectations for monetary easing in July or September have only exacerbated the trend—particularly among intermediate-term issues.

In addition, the Fed’s preferred price index has been running below 2%.2 Diminished inflation expectations have helped spur demand for fixed income assets, which has further depressed yields.

Few predicted rates would go this low

While market prognosticators were accurate in forecasting a flattening in the yield curve, few imagined that interest rates would fall as low as they have.

In fact, in a survey of 69 economists conducted by the Wall Street Journal in December, not one respondent predicted that 10-year Treasury yields would fall below 2.5% in 2019. In fact, most believed the 10-year yield would settle at 3% by mid-year.3

Our friends in the dismal science can be excused for their inaccuracy, because at the time the Fed was still signaling more rate hikes. In reality, the Fed has stood pat as economic concerns have mounted. Fed funds futures now predict a 100% chance of at least one rate cut in the third quarter.4

But with interest rates already falling, the Fed’s ability to mastermind monetary policy is severely undercut—which is precisely why Fed policymakers wanted to move toward a normalized rate environment in the first place.

What can investors make of all of this?

• Short-term rates may have peaked: While the partially inverted yield curve has propped up short-term yields of late, don’t expect yields on cash and cash-like securities to go higher in the current environment—especially with potential accomodative actions on the horizon.

• Keep an eye on housing: Lower interest rates have supported home prices and could prompt a new wave of refinancing, which could benefit the housing market.

• The hunt for yield is back: With interest rates on the decline, investors may be tempted to seek yield in income-oriented asset classes like REITs or high-yield bonds. But those same asset classes could be at greater risk if the economy falters. Bottom line: Know your tolerance for risk.

• Dividends may start to look attractive. Dividend-paying stocks could see a pickup in demand if bond yields continue to falter. Dividend payers may not be as exciting as growth stocks, but the income they can generate could compensate for the dearth of yield opportunities in the fixed income space. As with higher-yielding bonds, however, it’s important to know what you’re getting into. Yield is only one component of a stock’s return.

This touches on a broader discussion about strategies for a declining rate environment, which we’ll cover in more detail in the not-too-distant future. In the meantime, stay alert—and watch out for falling interest rates.

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PLEASE READ THE IMPORTANT DISCLOSURES BELOW.

All bonds and fixed income products are subject to interest rate risk and you may lose money. Bonds sold by issuers with lower credit ratings may offer higher yields than bonds issued by higher rated or "investment grade" issuers, but are usually associated with higher risks. High yield bonds, also known as "junk bonds", generally have a greater risk of default, which increases the risk that an issuer may be unable to pay interest and principal on the issue. In addition, high yield bonds tend to have higher interest rate risk and liquidity risk, particularly in volatile market conditions, which makes it more difficult to sell the bonds. Before investing in high yield bonds, you should carefully consider and understand the risks associated with investing in high yield bonds.

Investing in Commodities, REITS, Bonds, and International or Global investments carries certain risks such as price volatility, currency risk, market risk, interest rate risk and credit risk. An investor should fully understand these risks before making an investment.

Investment in real estate investment trusts (REITs) is subject to many of the risks associated with direct real estate ownership and, as such, may be adversely affected by declines in real estate values and general and local economic conditions.

Dividend yields provide an idea of the cash dividend expected from an investment in a stock. Dividend yields can change daily as they are based on the prior day's closing stock price. There are risks involved with dividend yield investing strategies, such as the company not paying a dividend or the dividend being far less than what is anticipated. Furthermore, dividend yield should not be relied upon solely when making a decision to invest in a stock. An investment in high yield stock and bonds involve certain risks such as market risk, price volatility, liquidity risk and risk of default.

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